Wednesday, December 21, 2011

Updated April 2013Some
months ago, I wrote a posting about both federal and state pension plans, the
funding gap between their current balances and their future liabilities and how
this was going to impact American taxpayers who are on the hook for the
shortfall. Thanks to the C.D. Howe Institute, a Canadian think-tank, we
now have a brief entitled "Ottawa's Pension Gap: The Growing and
Under-reported Cost of Federal Employee Pensions" which outlines how the issue
will impact Canadian taxpayers. Let's dive in and see what the authors,
Alexandre Laurin and William Robson, had to say.

Canada's
public servants are beneficiaries of defined benefit pension plans (DB). Three
of the largest federal government DB pension plans are provided to the Public
Service, the Canadian Forces and the RCMP. On top of that, Members of
Parliament and federal judges have special plans; those of MPs are considered
by many to be the ultimate in gold-plated pensions since they qualify for the MP
pension after just six years of service which they can collect at the advanced
age of 55. How many of us could say that? According to the Canadian Taxpayers Federation, the current DB pension plan
requires taxpayers to fork over $5.50 for every $1 contributed by any given MP.
For your illumination, here is the Canadian Taxpayers
Federation calculations for pensions and severance payments owing to the MPs
that were defeated in the May 2011 General Election.

Back
to the C.D. Howe brief. In the private sector, DB pension plans must
calculate the difference between their future obligations and assets using
actual market yields. Not so for public sector pension plans. Public
sector plans are allowed to use made-up rates of return to value their plans. Unfortunately,
generational lows in interest rates have made these assumed rates of return
unreasonable, resulting in growing unfunded liabilities.

Canada's
public sector pension assets total $54 billion in 2011, future accrued
obligations total $213.3 billion and unamortized estimation adjustments total
$13.2 billion for a total future liability of $146.1 billion. However, if
one replaces the government's current smoothed liabilities of $213.3 billion
with a fair value approach that better reflects market rates of return that are
currently available. Right now, the government is using a real assumed
rate of return of 4.2 percent (note, that's the nominal or posted interest rate
plus 4.2 percent for inflation) on all fund assets for benefits that were
earned since 2000. The government also uses a moving average of past
nominal yields on 20 year federal bonds in its calculations, again, these rates
are well above what one would expect in the past few years.

If
an individual Canadian wanted to set up a pension plan that mirrored the plan
available to Canada's public sector workers, they would have to index their
savings to inflation. The best measure of this index is a Canadian
government real return bond. This is where the problem crops up. As
noted in the previous paragraph, Ottawa is using a real return of 4.2 percent;
unfortunately, the actual return on the real return bond is now just over
one-half percent. According to the Bank of Canada website, real return bond yields have
ranged from a high of 3.76 percent in December of 2001, falling to 0.53 percent
in December 2011 with an average of 2.07 percent over the 10 year period. Here
is a graph showing all of the data:

We
can now readily see that the 4.2 percent real return is highly optimistic. The
C.D. Howe recalculated the assets that would be required to fund Ottawa's
pension promises using a "fair value" 1.15 percent yield and finds
that Ottawa's obligations would rise from $213.3 billion to $285.2 billion. If
one subtracts a new assets fair value of $58.6 billion, the unfunded pension
liabilities rise from $146.1 billion to $226.6 billion, a difference of $80.5
billion. If one substitutes the current 0.5 percent rate on real return
bonds, the future funding shortfall is even greater. Since the Canadian
taxpayer will ultimately be responsible for these shortfalls, the $80.5 billion
should actually be added to Canada's debt. According to Statistics Canada's latest economic and
financial data report, Canada's accumulated federal debt reached $568.140 billion
as of September 2011. If we add in the realistically calculated unfunded
public sector pension liabilities, the debt rises by 14.2 percent to $648
billion. Since, in fact, this $80.5 billion shortfall was accrued over a
number of years, the surpluses of the past decade were actually smaller than
reported and the deficits were larger. For example, the 2010 - 2011
deficit would have risen from its reported value of $31 billion to almost $47
billion, a rather significant change.

Another
point of concern is the growth in the funding gap. Here's how the growing
gap between reported pension obligations and the fair-value estimate has looked
over the past decade:

The
authors suggest that the Canadian government has two ways to fix this mounting
problem:

1.)
Eliminate the final-salary-based DB plan and replace it with a
career-average-salary plan and eliminate the early retirement option.

In summary, the rising gap between Canada's public service
pension assets and its future liabilities should concern every Canadian since
we are all ultimately responsible for the shortfall. Just as Canada's
private sector employees are looking to retire, they may find themselves paying
much higher taxes to fund their country's public sector pensions. That
will most likely be a terribly unpalatable prospect.

If they raise the contribution rates, they will have to allow everyone else to contribute more also, and that will lower tax revenue. Isn't the government's topping up, via a DB plan, a hidden way to allow them to get the benefits of contributions they never made, while denying us the same extra contribution? Also, effectively having both more salary, and never paying tax on it? Real sneaky what insiders do for themselves.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.